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...FASB board and staff asked the Financial Accounting Standards Committee of the American Accounting Association (hereafter, the Committee) to provide comments on concepts-based standards and to recast two standards as concepts-based. (2) This article summarizes comments of the Committee on issues related to concepts-based vs. rules-based standards. Comments in this article reflect the views of the individuals on the Committee and not those of the American Accounting Association.
The Committee strongly supports the commitment by the FASB to evaluate the feasibility of concepts-based standards. (3) We believe that the economic substance, not the form, of any given transaction should guide financial reporting and standard setting, and that concepts-based standards represent the best approach for achieving this objective. Rules-based standards provide companies the opportunity to structure transactions to meet the requirements for particular accounting treatments, even if such treatments don't reflect the true economic substance of the transaction. We recognize, however, that the current plethora of detailed rules has been demand-driven, suggesting that companies may request more guidance than that provided by concepts-based standards. Additionally, change from rules-based to concepts-based standards magnifies the importance of informed professional judgment and expertise for implementation of standards. Overall, however, we believe that concepts-based standards, if applied properly, b etter support the FASB's stated mission of "improving the usefulness of financial reporting by focusing on the primary characteristics of relevance and reliability...."
RULES-BASED VS. CONCEPTS-BASED STANDARDS
An Illustration of Rules-Based and Concepts-Based Standards
In order to make our discussion of concepts-based vs. rules-based standards more concrete, we characterize the accounting standard-setting process and its products as a continuum ranging from unequivocally rigid standards on one end to general definitions of economics-based concepts on the other end. An example of the extreme left (rigid) end of the continuum is:
Annual depreciation expense for all fixed assets is to be 10 percent of the original cost of the asset until the asset is fully depreciated.
Such a rule leaves no room for judgment or disagreement about the amount of depreciation expense to be recognized. Comparability and consistency across firms and through time is virtually assured under such a rule. However, such a standard lacks relevance due its inability to reflect the underlying economics of the reporting entity, which differ across firms and through time.
At the opposite (right) end of the continuum is a provision or rule such as the following:
Depreciation expense for the reporting period should reflect the decline in the economic value of the asset over the period. (4)
Such a standard requires the application of judgment and expertise by both managers and auditors. The goal is to record economic depreciation of the asset, something about which the manager arguably has more information than anyone else. Many might agree that such a rule reflects the underlying purpose of financial reporting, but argue that it is too costly to implement and would likely lead to results that are neither comparable across firms nor consistent through time.
Benefits and Costs of Rules-Based vs. Concepts-Based Standards Rules-Based Standards
Evidence abounds that detailed standards cannot meet the challenges of a complex and rapidly changing financial world, and that they frequently provide a benchmark for determining compliance in form but not in substance (Finnerty 1988). The Committee believes it is impracticable, if not impossible, for any standard-setting organization to anticipate and provide for every possible form and type of financial transaction and business relationship. Detailed standards are likely to be incomplete or even obsolete by the time they are published. In addition, such detailed standards provide self-interested managers the opportunity to manipulate the reported results under the guise of complying with the rules. In turn, auditors find it more difficult to thwart such manipulations of reported financial results when detailed rules serve as the managers' justification.
The Committee offers two examples of these problems associated with rules-based standards. The first example is accounting for leases. SFAS No. 13 is a rules-based standard with a list of four precise criteria, several of which contain numerical cut-off points, and the requirement that if any one of the criteria is met, a company must account for the lease as a capital lease. However, the application of these criteria has been controversial since the promulgation of the standard, with the subsequent issuance of hundreds of pages of documentation dealing with leases; for example, see the FASB's 450-page Accounting for Leases--A Codification as of October 1, 1998. Additionally, professional expertise, creative arrangements such as synthetic leases, and judgment have been applied to circumvent the accounting rules rather than to present financial statements that reflect the underlying economics of the transaction. For example, Pulliam (1988) reports that third-party guarantors of the residual values of leased as sets developed contracts to avoid the "90 percent present value of minimum lease payments" threshold imposed by SFAS No. 13. Imhoff and Thomas (1988) find that the most common effect of SFAS No.13 was the substitution of operating leases for capital leases, presumably in order to avoid liability recognition.
The second example is pooling vs. purchase accounting for business combinations. APB No. 16 contained a list of 12 conditions necessary to qualify for pooling, an apparently bright line standard. However, even with these precise conditions, Michael Sutton, former Chief Accountant of the SEC, estimated that his staff spent 40 percent of their time fielding questions on whether specific transaction structures could qualify for pooling treatment (McGoldrick 1997). Lys and Vincent (1995) document an extreme case in which AT&T paid as much as $500 million in order to gain SEC approval of the pooling-of-interests method of accounting for its acquisition of NCR. (5)
In highlighting these problems, the Committee turns to the Internal Revenue Service (IRS) for analogy as to the effects of bright line rules. The IRS relies on the Internal Revenue Code (IRC), Treasury Regulations, rulings, and case law to establish whether taxpayers have violated the rules--a negative standard of conduct. There is general consensus among IRS constituents that tax rules have become fearsomely complex, detailed, cumbersome, and costly, as they attempt to restrict transaction structuring that accompanies such bright line rules. Thus, detailed tax regulations can facilitate a "form over substance" treatment of an item. (6) We believe the tax code and regulations provide a negative example for the FASB, and that accounting standard setters should provide guidelines for which there is a positive standard of conduct, relying on substance over form and reflecting underlying economics rather than compliance with an arbitrary standard.
Concepts-Based Standards
The committee recognizes that the latitude inherent in concepts-based standards is a double-edged sword. Such latitude allows managers to choose accounting treatments that reflect their informed understanding of the underlying economics of transactions. This latitude, however, also permits managers to advocate reporting treatments that do not reflect the underlying economics of a transaction. Managers, audit committee members, and auditors must possess both expert judgment and a desire for unbiased reporting in order for conceptual standards to result in financial reporting that reflects underlying economics. Both the SEC and the Auditing Standards Board support this view with their...
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